Weak Stock Market Exposes Accountants' Sleight-of-Hand

While accounting wizardry may have helped to obscure a vast multitude of corporate sins and weaknesses during the 1990s bull market, the smokescreen is growing patchier each day as a burgeoning list of formerly high-flying stocks flirt with 12-month lows.

One of them, Microsoft, fooled no one last week when it reported slightly higher-than-expected earnings of 44 cents a share for the second quarter -- two cents above consensus estimates and four cents over its year-earlier net.

One needn't have looked very far to ferret out a more truthful and sobering picture, however. In fact, an estimated 20 percent of the software giant's bottom line came by way of a $650 million gain realized on its vast investment portfolio.

Moreover, by some analysts' reckoning, operating income -- profits minus such non-recurring items as portfolio gains-- actually decreased by four cents year-over-year, to 30 cents per share.

Earnings were announced after the close of trading on Wednesday, but aggrieved shareholders were lined up the next morning, eager to bid Microsoft an unkindly adieu. The stock opened down $2.50 and continued to fall, closing off $5.38 on the day, just above its intraday low.

The somewhat speculative provenance of Microsoft's portfolio gains might have been viewed less skeptically back in March, when the stock traded as high as $115 and shareholders were probably feeling smug rather than vindictive.

But with shares currently wallowing 40 percent below their all-time highs, and with new-product sales in the doldrums, Microsoft's spinmeisters did double-shifts into the weekend in an attempt to cast things in their best light.

Unfortunately, they did not have much to work with.

For starters, sales of Windows 2000 have been sluggish, dimming hopes that the high-powered operating system will soon offset decelerating revenues from Microsoft Office, a maturing line that presently accounts for about a third of the Redmond, Washington company's total revenues.

As for its portfolio of securities, Microsoft cautioned analysts not to expect such a strong performance in the next quarter. Any investor who is weighted in the tech sector knows exactly what they mean.

On the same day, another corporate bellwether, Intel Corp., announced its earnings, which were couched even more cleverly than Microsoft's.

The Silicon Valley chip-maker reported a 79 percent surge in income on net revenues of $3.14 billion. But by day's end, Wall Street analysts had talked themselves dizzy trying to figure out whether the numbers were really all that good.

Thwarting any meaningful analysis by them -- by anyone, actually -- were a few special items and adjustments that included a $2.1 million net gain on the sale of securities from the company's investment portfolio, and a coyly reckoned 2-for-1 stock split that won't even be effective for another week.

In the past, analysts have not seemed much disturbed when Intel and other firms treated investment gains as ordinary income. But seldom if ever have such gains been on the order of $2.1 billion, and until relatively recently, few companies held investment portfolios the size of Intel's, presently assessed at around $7.5 billion.

Financial analysts are growing increasingly uncomfortable with the implications, for it is difficult enough for them to estimate how a company will perform in its core business from one quarter to the next.

Their task becomes exponentially more difficult, however, when the publically held firms they track are subject to billion-dollar earnings swings driven in large part by a stock market that in the last year has turned wildly volatile.

We needn't weep for the analysts, of course, since they will always find a way to eat. But if The Street's best and brightest are having trouble figuring out how companies are really doing, the average investor is just shooting in the dark.

To be sure, during the long bull market, muddled or flawed thinking produced gains for millions of investors that were little short of spectacular.

But when stocks start to fall, as Japanese investors learned a decade ago, those easy profits will vanish overnight.

As we have come to recognize, the impressive Japanese financial edifice of the 1980s was built mainly by big companies who acquired and held each other's shares and who then deployed a significant portion of their stock-market gains in real estate.

The resulting wealth effect -- in retrospect, a grand illusion -- was so convincing that most Japanese investors came to believe that share prices commanding a hundred times earnings or more was absolutely normal, and that real estate priced even more extravagantly was a bargain.

Ten years later they are still paying for their poor judgment.

Meanwhile, U.S. investors seem to have learned little from Japan's decade-long economic misery. We are no doubt comforted by the belief that Cowboy Capitalism, having shunned the incestuous and conspiratorial practices of Japan, Inc., has laid a solider foundation on which to build wealth.

Perhaps. But it should be evident to all that in a bear market, the huge stock portfolios held by U.S. companies will make them every bit as vulnerable to collapse as Japanese companies were in the 1980s, even if the U.S. firms are not quite so heavily weighted in real estate.

The downward spiral in share prices that will occur when companies with falling earnings must report losses on shares held in other companies with falling earnings is disquieting to contemplate.

By then, the pumped-up capitalism we've enjoyed for years may start to seize, like a steroid abuser's vital organs.